Minority
Shareholders and Derivative Actions

Christian
Chin elaborates on the common law and statutory derivative actions available for
the protection of minority shareholders.

Introduction

Where
a wrong has been done to a company and no action is being taken to remedy this
wrong, there are several courses of action that are open to a member of the
company:

a member may request the board of directors to take action on behalf of the
company; or

he may requisition a general meeting for the purpose of passing a resolution to
commence litigation;1 or

if neither of the above is possible, then the member may either:

commence an action against the defendants himself; or

apply to the court under section 216A for leave to bring an action in the
company’s name.

Where
the potential defendant is in a position to thwart the efforts of those seeking
to enforce the company’s legal rights by bringing an action against the
potential defendant, the only courses of action open to a member would be those
enunciated in the third option above

Common
Law Derivative Action

A
member of a company can commence an action against the defendants himself where
he can demonstrate that the case at hand comes within one of two exceptions to
the rule in Foss v Harbottle (1843) 2 Hare 461 (also known as the
‘proper plaintiff’ rule, which, briefly, states that no member can arrogate
to himself the company’s cause of action).

The
ultra vires exception

As
an action to restrain an ultra vires act is an action seeking to enforce a
member’s personal rights, the rule in Foss v Harbottle does not operate to
prevent a member doing so. However, as an ultra vires act is not void vis-à-vis
a third party (see section 25(1) of the Companies Act (Cap 50)), the question of
recovery of the company’s property from a party to an ultra vires transaction
would, therefore, not arise. This means that for all practical means and
purposes, the ultra vires exception to the rule in Foss v Harbottle is
effectively defunct.

The
fraud on the minority exception

If
there has been a fraud on the minority and the wrongdoers are in control of the
company, a minority member may bring an action to enforce the company’s
rights. However, it is important to bear in mind that this exception is merely a
procedural device to enable justice to be done. As such, a member has no right
to bring such an action. The court maintains its discretion to disallow a member
from bringing such an action if he does not come with ‘clean hands’ or where
the justice of the case otherwise dictates that such an action should not be
allowed (Nurcombe v Nurcombe [1985] 1 All ER 65). In determining what amounts to
a fraud on the minority for the purpose of allowing derivative actions, it
appears that the courts tend to allow for a more generous interpretation as
compared with fraud at common law, including within its ambit fraud in the
equitable sense (eg where there is an abuse of power — Estmanco (Kilner House)
Ltd v Greater London Council [1982] 1 All ER 437). Furthermore, it appears from
the study of relevant case law that fraud on the minority would exist where the
majority uses their voting power in a manner that the law regards as
illegitimate to cause some injury or loss to the company or to the minority
members. This is weighed against the countervailing principle that a member has
a right to vote as he pleases; which dictates that where the majority votes to
excuse a breach or waive a right, the minority is bound by that vote and may not
sue in defiance of the majority’s decision. The balance is struck where fraud
is being perpetrated on the minority — in such cases, the power of the
majority to pass resolutions is necessarily circumscribed and the decision of
the majority will not be binding on the minority.

It
has been suggested that a general rule for establishing fraud on the minority
can be culled from the study of relevant case law. This proposed rule calls for
three requirements to be satisfied:

the benefit must have been obtained at the company’s expense or some loss or
detriment must have been caused to the company;3 and

the majority used their controlling power to prevent an action being brought
against them by the company.4

Statutory
Derivative Action

Despite
of the courts’ efforts to come up with a general rule for determining when
there has been a fraud on the minority, the uncertainty of its application and
the haphazard procedure that has to be followed in bringing such an action gave
rise to the enactment of sections 216A and 216B in the Companies (Amendment) Act
of 1993, which together sought to clarify and reform the situation regarding
derivative actions.

Procedure

Section
216A substitutes the ad hoc procedure involved in common law derivative actions
with a two part procedure requiring a complainant5 to, firstly, apply to court
for leave to commence an action on behalf of the company and, secondly, upon
obtaining leave of court to commence such an action, to take the necessary steps
to initiate the action using the company’s name.

Before
applying to court to commence an action under section 216A, the complainant must
first give fourteen days’ notice to the company’s directors to give them a
reasonable opportunity to commence the action themselves (section 216A(3)(a) —
this requirement for fourteen days’ notice, however, is not an absolute rule
and is open to the complainant to show, in each instance, why notice could not
be given). This notice should state what it is that the complainant wishes the
directors to do. As the law recognises that it would be unduly onerous on the
complainant to require the complainant to specify each and every cause of action
in the notice (see Re Bellman and Western Approaches Ltd (1981) 130 DLR (3d)
193, where it was held that a complainant’s failure to specify each and every
cause of action in a notice did not invalidate the notice as a whole), all that
is necessary to fulfil this requirement is that the notice ‘sufficiently
specifies the cause of action and contains sufficient information to found an
endorsement on a writ’ (Re Northwest Forest Products Ltd [1975] 4 WWR 724). If
the directors consider the matter and honestly decide that it would not be in
the company’s interest to commence or defend the action, the court would not
intervene. This is because it is neither the role nor the function of the courts
to hear appeals from management decisions honestly arrived at (Howard Smith
Ltd v Ampol Petroleum Ltd [1974] AC 821).

At
the hearing of the application, the court must be satisfied that the complainant
is acting in good faith and that it is prima facie in the interests of the
company that the action should be brought before granting leave to commence the
action (section 216A(3)(b) and (c). In deciding whether or not the latter
requirement has been satisfied, two factors usually weigh heavily on the
courts’ mind. The first is whether or not there is an arguable case against
the proposed defendant; the second is that extraneous considerations may be
taken into account in deciding whether or not to commence an action on behalf of
the company. This is because the courts acknowledge that the decision whether or
not to commence an action on behalf of the company is often as much a matter of
business as of law. It would therefore be fair to assume that the fact that the
majority have decided against pursuing the action is a factor that courts would
take into account in deciding whether or not to grant leave.

If
the court decides to grant leave to the complainant to commence an action, the
court has the power to make an order requiring the company to pay reasonable
legal fees and disbursement incurred by the complainant in connection with the
action (see section 216A(5)(c)). The court may, in suitable cases, only order a
partial indemnity (Turner v Mailhot (1985) 28 BLR 222).

In
addition to the power to order payment of costs, the court has a wider power to
make such other orders as it thinks fit in the interests of justice (section
216(5)). This would presumably give the court the power to grant a complainant
access to a company’s records in order to make it easier for a complainant to
gather evidence to buttress his case against the wrongdoers.

While
it is clear that the cumulative effect of the above provisions is to
considerably strengthen the position of minority shareholders vis-à-vis the
majority, section 216A is not without its shortcomings, two of which will be
discussed below.

Who
may intervene?

Section
216A goes further than the common law derivative action in the protection of
minority shareholders. This is because section 216A allows a complainant to
intervene in an existing action, whereas the common law merely allows a minority
shareholder to bring an action. A situation may, therefore, arise whereby
shareholders take turns to hijack an action, resulting in a carousel of
applications being made by the shareholders. While this is less likely to arise
due to the court’s supervision, the courts may still be placed in a quandary
where a complainant applying to court satisfies the section 216A requirements
but is nevertheless not the most appropriate person to bring the action. It then
falls for the court to decide whether or not to allow the complainant to go
ahead with the action, bearing in mind the possibility that another party may
apply to take over the proceedings.

The
fact that there is no time limit within which a complainant must make an
application further exacerbates this problem. This is because a potential
complainant, being comforted by the knowledge that he may jump into the fray
anytime to intervene in the action, lacks the necessary impetus to act
expeditiously in the matter.

Another
curious upshot of the width of section 216A is that there may be a situation
whereby the majority manages to wrest control of the action from the minority.

An
unnecessary divide?

Section
216A does not apply in the case of listed companies. The rationale for this
appears to be twofold. Firstly, there is a concern that unscrupulous people may
take advantage of this provision to make frivolous applications to harass listed
companies and even manipulate their share prices. Secondly, it is believed that
minority shareholders of listed companies do not require as much protection as
those of other companies as discontented shareholders of the former may divest
themselves of their interest more easily than those of the latter.

It
is difficult to be convinced that the above rationalisations are sufficient to
justify maintaining separate regimes for bringing derivative actions. This is
because it is no easier to make an application to bring an action under section
216A than it is under the common law. Neither is it necessarily true that
shareholders of listed companies are less desirous of protection than those of
unlisted companies. In fact, one would think that there is a greater need to
protect the shareholders of listed companies from mismanagement.

Conclusion

Thus,
while section 216A goes some way towards developing the law in respect of
corporate derivative actions, it is equally evident that it is far from a
panacea to the ills of the common law derivative action. The need to fine tune
section 216A as a comprehensive provision for derivative or representative
actions is particularly pressing in light of a recent High Court decision
holding that section 216A is the only recourse open to a minority shareholder
who wishes to commence a derivative action against the directors of a company
for alleged misfeasance against the company. If the only recourse available is
fraught with uncertainty, it is unlikely that a minority shareholder will seek
this recourse. Should this be the case, then all the efforts that have gone into
seeking to enhance the minority shareholders’ position vis-à-vis the
controlling majority would have come to naught.

Christian
Chin

Drew
& Napier

Endnotes

1
Members may authorise actions to be brought in the company’s name despite the
opposition of the board of directors — Marshall’s Valve Gear Co v
Manning, Wardle & Co [1909] 1 Ch 267.

2Pavlides v Jensen [1956] 2 All ER 518 — a minority member would not be
allowed to maintain an action on the company’s behalf if the wrongdoer obtains
no benefit for himself.

3Regal (Hastings) Ltd v Gulliver [1942] 1 All ER 378 — the majority
should be allowed to forgive a breach of duty where the company has suffered no
loss.

4
There is little reason to allow an exception to the rule in Foss v Harbottle
where the defendant is not in control of the company. In relation to this
requirement, it is clear that what amounts to ‘control’ is a question of
fact to be decided by the courts. Clearly, there is little doubt that a person
holding the majority of shares in a company would have control of the company.
However, there may be instances where a party holding less than the majority of
shares may fairly be considered to have control of the company. It has also been
decided that it is permissible to go behind the apparent ownership of the shares
to determine if a company is in fact controlled by the wrongdoers (eg where the
shares are held on trust for someone else).

5
‘Complainant’ is defined as either any member of a company, the Minister of
Finance in the case of a declared company or any other person who, in the
discretion of the court, is a proper person to make an application.